Stock Valuation and Characteristics

Podcast

Play an AI-generated podcast conversation about this lesson

Questions and Answers

What does the dividend yield (DY ratio) represent?

The market price of net assets compared to their purchase cost.

The ratio of a company's stock price to its book value.

The rate of return on an investment based on dividends received. (correct)

The time it takes to recover the initial investment in years.

How is the price earnings (PE) ratio calculated?

Price of share / book value per share

Earnings per share / price of share

Price of share / dividends per share

Price of share / earnings per share (correct)

What does the Price to Book (PB) ratio indicate?

How long it will take an investor to recover their investment.

The total market cap of a company.

The company’s earnings relative to its costs.

The relationship between the market price and the book value of the company. (correct)

What is the key idea behind the Efficient Market Hypothesis (EMH)?

Market prices reflect all available information. Signup and view all the answers

According to Malkiel's view, what is the recommended investment strategy?

Invest passively and track the market using an ETF. Signup and view all the answers

What happens to the principal amount of purchased shares?

It remains with the company indefinitely. Signup and view all the answers

Why are dividends considered taxable income for shareholders?

Because dividends are distributed from company profits. Signup and view all the answers

What characterizes Treasury Stock?

It comprises shares repurchased by the issuing firm. Signup and view all the answers

What are preemptive rights designed to prevent?

Dilution of ownership for current shareholders. Signup and view all the answers

In which market are initial public offerings (IPOs) conducted?

Primary market. Signup and view all the answers

What is a bull market characterized by?

Rising stock prices. Signup and view all the answers

Which of the following statements is true regarding cash dividends?

They are paid periodically from company earnings. Signup and view all the answers

How does Treasury Stock effect voting rights?

It eliminates all voting rights for the shares. Signup and view all the answers

What is the price per share for Company X using the Gordon Growth Model (GGM)?

$94.50 Signup and view all the answers

During the super growth period, what will the dividend at the end of Year 3 be for MEGA PLC?

£10.985 million Signup and view all the answers

What discount rate is used in the valuation of MEGA PLC?

20% Signup and view all the answers

What describes a bear market?

A market with prolonged price declines Signup and view all the answers

Which of the following is NOT a method used in fundamental analysis?

Technical indicators Signup and view all the answers

What is the total value of MEGA PLC today according to the two-stage Dividend Discount Model?

£87.58 million Signup and view all the answers

What does the formula for present value consider?

Future value and interest rate Signup and view all the answers

What would be the value of one share of MEGA PLC if 20 million shares are in issue?

£4.38 Signup and view all the answers

In the Dividend Discount Model, if the risk-adjusted discount rate is higher, what is the effect on the stock's present value?

The present value decreases Signup and view all the answers

What happens to the growth rate after the initial super-growth period in MEGA PLC?

It drops to 10% Signup and view all the answers

What is the expected terminal dividend growth rate if a company expects dividends to grow at 5% perpetually?

5% Signup and view all the answers

What method can be used to value companies that do not pay dividends?

Residual Income Model Signup and view all the answers

How is the present value of the dividend in Year 2 calculated for MEGA PLC?

£8.45 / (1+0.20)^2 Signup and view all the answers

How do you calculate the value of stock today using the Dividend Discount Model?

By discounting future dividends to their present value Signup and view all the answers

What does the Gordon Growth Model assume about dividends?

Dividends will grow at a constant rate indefinitely Signup and view all the answers

What would be the present value of three annual dividends of $200 each, discounted at a rate of 8%?

$515.42 Signup and view all the answers

What distinguishes common stock from bonds in terms of maturity?

Common stock does not have a maturity date. Signup and view all the answers

How do shareholders contribute to corporate governance?

They have the right to vote in board elections. Signup and view all the answers

What is meant by 'residual claim' in the context of common stock?

Stockholders claim the remaining assets after all non-owner claims are settled. Signup and view all the answers

What is a characteristic of 'super voting rights'?

They enable shareholders to cast more than one vote per share. Signup and view all the answers

What role do proxies play in corporate governance?

They transfer voting rights to another party. Signup and view all the answers

Why are common stocks considered a major financing vehicle for corporations?

They allow companies to raise capital without obligations. Signup and view all the answers

Which of the following statements about the ownership provided by common stock is true?

Shareholders are entitled to vote on company management. Signup and view all the answers

What impact does holding non-voting stock have on a shareholder's influence?

It reduces their ability to influence management decisions. Signup and view all the answers

What does the clean surplus relationship equation indicate?

Earnings per share minus dividends per share equals change in book value per share. Signup and view all the answers

In the residual income model, which variable is NOT required for calculating the valuation?

Dividends per share Signup and view all the answers

Using the residual income model, what is the correct formula to calculate V0?

$rac{EPS1 - B0 * g}{k - g}$ Signup and view all the answers

What is the calculated value per share for Company X?

£19.46 Signup and view all the answers

Which of the following reflects the correct calculation of Free Cash Flow (FCF)?

Profit after tax + depreciation - capital expenditure Signup and view all the answers

If the cost of capital is 0.13 and the growth rate is 0.03, what must be true for FCF valuation?

g must be less than k Signup and view all the answers

What is the value of equity for Company Z if its total asset valuation is ¥329.6m and market value of debt is ¥100m?

¥229.6m Signup and view all the answers

What is indicated by the free cash flow calculation for a company?

It assesses the cash generated by assets after necessary expenditures. Signup and view all the answers

Study Notes

Part 1: Stock and Stock Valuation

Learning Outcomes:
- Understand the basic characteristics of common stock.
- Explain the primary and secondary stock markets.
- Explain bull and bear markets.

Characteristics of Common Stock

Major Financing Vehicle: A core funding method for corporations.
Future Cash Flows: Holders share in the future cash flows of the issuing company.
Ownership: Holders own a part of the company.
No Maturity Date: Unlike bonds, there's no predetermined date for repayment.
Variable Income: In contrast to bonds, dividend payments can change periodically.

Ownership

Profits: Shareholders receive a portion of the company's profits.
Assets/Cash Flows: They have a claim on all company assets and cash flows (after creditors and other expenses are paid).
Voting Rights: Participate in company management by voting for board members.

Claim on Assets and Cash Flow (Residual Claim)

Liquidation: In case of liquidation, shareholders have a claim on the residual assets and cash flow.
Balance Sheet:
- Assets reflect the company's value.
- Liabilities are claims on assets by non-owners.
- Owners' Equity = Assets – Liabilities.

Vote (Voice in Management)

Standard Voting Rights: Typically, one vote per share for shareholder elections and other company updates.
Altered Voting: Possible through issuing different categories of stock.
Non-Voting Stock: Issued temporarily.
Super Voting Rights: Gives shareholders multiple votes per share, influencing company decisions.
Proxies: Individuals can appoint another person to vote on their behalf.

No Maturity Date

Investment Return: No guaranteed date for investment return, but rather, the shareholder retains ownership until the company is dissolved or the shareholder chooses to sell their shares.
Permanent Financing: Represented as a permanent financing method.
Stock Repurchase: Companies might buy back their own stock (Treasury Stock), an exception to the no maturity date.

Dividends and Their Tax Effect

Periodic Payments: Companies distribute cash dividends periodically to shareholders - often quarterly.
Operational Income: These payments are distributed out of company earnings.
Non-Deductible Expense: Dividends paid are not a tax deductible expense for the company.
Taxable Income: Dividends received by shareholders are usually taxable income.

Treasury Stock

Non-dividend/ Non-voting Shares: Issued stock held by the company.
Repurchased Shares: Stocks that the issuing firm bought back.

Preemptive Rights

Shareholder Privileges: Existing shareholders get preferential purchasing rights over new shares.
Proportional Ownership: Ensures constant ownership percentages from the initial shareholders.
Example Scenarios: Explains how preemptive rights operate with examples.

Stock Markets

Types of Markets:
- Primary Market: Where the company initially issues shares to investors (often called IPO - Initial Public Offering).
- Secondary Market: Where existing shareholders trade shares among themselves (e.g. NYSE, NASDAQ, AMEX).

Bull Markets and Bear Markets

Bull Market: A period of rising stock prices.
Bear Market: A time of declining stock prices.

Part 2: Stock and Stock Valuation

Learning Outcomes:
- Overview of two primary methods for evaluating stock value.
- Analyzing stocks using the Dividend Discount Model (DDM).

Fundamental Analysis: Evaluating a business based on its financial statements (e.g., accounts).
Technical Analysis: Trends in company share prices.

Fundamental Analysis

Discount Models:
- Present Value of a company's future dividends/cash flows.
Free Cash Flows: Future earnings available to shareholders and company creditors.
Ratios: Price-to-earnings (PE) ratio and others are useful measures of comparison.

Discount Models

Value of something: Represents the amount received for an item - for stocks it includes dividends over the period of ownership and a final sale amount.
Time Value of Money: In most cases, money has more worth today than it would have at a future date because of potential earnings through interest.

Dividend Discount Model (DDM)

Stock Valuation Formula: An equation for calculating the value of a stock based on its future dividend payments, present value, and growth rate.

DDM with Constant Growth

Gordon Growth Model (GGM): A method for valuing stocks when dividend payments are predicted to grow at a steady annual rate.
Growth Rate calculation: Formula illustrating the method to calculate the value today.

Two-stage DDM

Super-growth period: Stock experiencing extraordinary growth in the beginning.
Constant growth period: Steady and predictable dividend growth (later time-periods).
Example: Provides steps for calculating the stock valuation in a scenario where growth rates fluctuate.

Valuation Ratios

Dividend Yield: Shows the return based on the current price of equity.
Price-to-Earnings Ratio (PE): Analyzes how long it takes for earnings to cover the investment in the stock.
Price-to-Book Ratio (PB): Reveals market value in comparison to equity book value.

Technical Analysis

Investor Sentiment: Share pricing reacts to optimistic or negative investor viewpoints
Trends in Prices: Examining the overall trend in share prices to forecast the future.

Fama (1965)

Efficient Market Hypothesis (EMH): There is no advantage to be gained from buying and selling stocks on the basis of publicly available information
Information Efficiency: Stock prices represent all current knowledge that affects the company.
Weak, Semi-Strong, and Strong Efficiency: Different levels of market efficiency based on the information available to investors.

Three Forms of Market Efficiency

Strong Form: All information regarding a company, both public and private.
Semi-strong Form: All publicly available information.
Weak Form: Historical trading information.

Malkiel (1973)

Passive Investing: The best method of investing is not to try and beat the market.
Exchange Traded Fund (ETF): A way to track the market, investing in baskets of stocks on ETFs to represent the portfolio of the market.

Company Valuation (Continuing)

Methods:
- Residual income model
- Free cash flow model
- Valuation ratios
Technical analysis

Residual Income Model

Non-Dividend Paying Companies: Used to value companies without any dividend payment.
Clean Surplus Relationship: Company profits, when adjusted by dividends, are equal to the change in book value.

Free Cash Flow Valuation

Cash Flow, Not profits: Companies that aren't profitable can still generate cash flows.
Substitute Cash Flows: Applying a company's cash flow (instead of their earnings) to dividend calculations in a similar way to the residual income model.
FCF Formula: Free cash flow value is determined by adding depreciation to net profits and subtracting capital spending.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Description

Explore the essential features of common stock and the dynamics of stock markets through this quiz. You will learn about the ownership rights of shareholders, the significance of future cash flows, and the differences between primary and secondary markets. Test your understanding of bull and bear markets, and gain insights into stock financing.